Zero bank failure is the best deposit insurance policy
₹5 lakh) for any loss to depositors due to bank failure. That’s at the individual level. At the macro level, deposit insurance plays a key role in instilling confidence in the banking system, enabling it to lend to the real sector and thereby keep the wheels of the economy well-oiled and running.
The case for deposit insurance is, therefore, beyond dispute. Especially since technology and digitalisation of financial services, coupled with the (destructive?) role of social media in amplifying fear, means bank runs can be triggered more easily. This was brought home dramatically following the collapse of some prominent banks in the US and Europe in 2023.
Though the root cause of these failures might have varied—from liquidity mismanagement to flawed business models and failure to diversify across different classes of depositors—the role of uninsured deposits and related to that, the adequacy of deposit insurance coverage, came in for renewed attention soon after. Modern banking is based on the fractional reserve system, wherein banks retain a fraction of their deposits and lend the rest. Trust, or depositor faith, that the bank will be able to repay their deposits ‘on demand’ is fundamental.
The moment this faith is broken, the result is a run on the bank, which, if not nipped in time, can lead to a collapse. Sure, full insurance cover for deposits may seem ideal for depositors and help avoid bank runs. But this is a suboptimal solution given the associated moral hazards and financial non-viability.
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